Calling all accredited investors

What does it mean to be an accredited angel investor, and is the designation actually meaningful?

Startups want to work with accredited investors. Every investor in the New York Angels has to sign a form that they meet the requirements for accreditation set by the Securities and Exchange Commission (SEC).

But what does that really entail? By the SEC’s rules, accredited angel investors need to meet any one of three conditions

Assets of at least $1 million (not including the value of the primary residence)

Annual income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years

A reasonable expectation of the same income level in the current year.

The purpose of accreditation is to minimize the risk of investors risking more money than they can afford to lose. That’s a worthy goal. But the SEC’s approach is little more than a fig leaf. SEC regulators conveniently assume that if you have accumulated enough wealth to meet the requirements, you are sufficiently sophisticated to make prudent investments.

There are two things questionable about this approach. First, there is little evidence that wealth by itself makes investors any more sophisticated. As Chairman of the New York Angels, I’ve watched the investing patterns of dozens of angel investors. I don’t see any correlation between wealth and the ability to pick successful startups. Second, can we really be sure that investors meet the requirements? It’s all self-reported.

The SEC is on safer ground with the requirements it is preparing for a new era of democratized angel investing through crowdfunding or, more properly, crowdinvesting. The agency is dispensing with accreditation thresholds and instead protects investors by limiting the amount of money individuals can risk.

High-risk investments

Few investments are as high risk as angel investing. The payday for angel investors comes when the startups they invest in have an exit, usually an acquisition by a larger company (think Facebook acquiring Instagram) or an IPO (think Google). But angel investing is not a short-term play. Nine years is the average wait between investing and exit, in the extremely unlikely case even when there is one.

Most angel activity is still concentrated in Silicon Valley, but New York City’s Silicon Alley is rapidly catching up, now that New York Mayor Michael Bloomberg is pushing entrepreneurship. The New York Angels, recently rated the most active angel network, is proud to be a partner in the Mayor’s initiative to make New York City a major hub for angel investing.

What chance does the average angel have?

So, how well do angel investors do? The reality is that very few angels recoup their investments.

It’s impossible to get verifiable statistics on the financial returns of angel investors in the tech sector. The Angel Investor Performance Project by the Kauffman Foundation shows that the best estimate for average angel investor returns is 2.5 times their investment even though 50-75 percent of angels make less than what they invest. Diversification -- when angels bet on a number of startups using a portfolio theory model -- has been shown to help investors mitigate risk.

Given that the average VC fund barely makes money, and seed investments represent even less compelling opportunities than the ones pursued by venture capital firms, then returns are very unevenly distributed and this begs the question to what extent is portfolio theory fundamental to angel returns.

My answer is that individual angel investors must understand four things:

Assume you are going to lose all your money. Treat angel investing as an exercise in meeting the most interesting people in the world. Have fun at it, and you can’t lose.

Treat financial success as a complete surprise.

Diversify. A portfolio approach works in your favor. The law of small numbers is your enemy. Try to build a portfolio of at least a dozen startups.

Join an angel network like the New York Angels, which the Halo Group recently ranked the most active angel group in the US.

I come at angel investing with a great sense of optimism, all financial evidence to the contrary.

There is a big difference between being a professional angel investor and an amateur. All research shows that there is a better exit outcome when you employ best practices and are part of an Angel Group where the wisdom of crowds exits. Even crowdfunding will benefit from this approach.